In recent years, cryptocurrencies have been a top trending subject.
From Bitcoin’s meteoric rise, to the latest “altcoins” that promise eye watering returns, and the introduction of crypto ETFs in 2024 – the allure of getting rich quick, and the accessibility to the crypto market, has never been stronger.
But is putting your hard-earned money into the crypto market a wise financial decision for you and your financial future?
Today, we’ll help you to make informed decisions for yourself by explaining, in layman’s terms, both the temptations and the realities of cryptocurrency investments.
Why Is Cryptocurrency So Popular?
If you hear people mentioning cryptocurrency but don’t know much about it or why it has captured the imagination of so many people, here’s the basics of the “why”:
1. High Returns:
Early adopters of Bitcoin (and some other cryptocurrencies) have seen astronomical returns on their money.
Without understanding the mechanics or how this value has been created, the simple idea of turning a modest sum of money into a fortune is incredibly appealing for a huge number of people.
2. Hype & Media Coverage:
Combine those high returns with strong media coverage and intense hype across social media and social circles, this can create psychological pressure that can push individuals into herding behaviour and hasty investment decisions.
Stories of overnight millionaires flooding our media channels, our social media feeds, and our dinner table discussions can create a strong sense of FOMO (Fear Of Missing Out).
3. Decentralisation:
Getting into the more technical, cryptocurrencies operate on “decentralised” networks, which means that they sit outside the control of traditional institutions and the traditional banking & financial system.
For crypto advocates, this gives a sense of empowerment – and for those with more extreme views, paves a path towards a new way of doing things and a new era of financial freedom “outside the system”.
4. Technological Innovation:
For many, the appeal is something beyond Bitcoin itself, it’s with blockchain – the technology underpinning most cryptocurrencies.
Essentially, a blockchain is a digital ledger that records transactions across a network of computers.
Many crypto investors hail this technology as a revolutionary development that could have applications beyond the world of crypto (for example, financial services, supply chain management, voting systems, and healthcare are often cited as potential industries that could benefit).
The Reality & Risks of Cryptocurrency
However, it’s important to remember the dynamics of the relationship between risk and return – generally, you cannot increase return without also increasing risk.
And there are significant risks associated with cryptocurrencies, which many people either ignore or are unaware of. If you do choose to allocate your hard-earned savings to cryptocurrencies, ensure that you are making a fully informed decision:
1. Bitcoin is not an “Investment”:
Fundamentally speaking, cryptocurrencies are not actually investments at all.
They are digital currencies.
By definition, an investment is expected to produce a future stream of income.
For example, real estate will produce rental income, company stocks will produce profits and dividend income, and bonds will produce interest income.
Cryptocurrencies do not produce a stream of income.
Thus, its “value” increasing depends not on fundamental factors, but entirely on Greater Fool Theory (i.e. a “greater fool” must come along and pay more for it).
As such, as a starting point for any thought exercise around cryptocurrency, investors should remember to classify cryptocurrency as “speculating”, not “investing”.
Speculating is also significantly higher risk than investing (even when comparing with a 100% equity-based portfolio), so investors should also keep this in mind when considering the overall allocation of their life savings.
2. Lack of Fundamental Valuation
To build on the point above, beyond the lack of income stream required to classify an asset as an investment, cryptocurrencies also lack any underlying fundamentals with which to value it.
For example, companies (i.e. stocks) report earnings, revenue, assets, liabilities, growth, etc.
Bitcoin has no balance sheet or any tangible valuation metric, so it is difficult to assess its true worth – relying almost entirely on hype, market sentiment, and Greater Fool Theory.
3. Volatility
Cryptocurrencies are notoriously volatile.
Prices and valuations can swing wildly within a short period. No doubt this can be partly attributed to the point above – with no fundamental “anchor”, who is to say what the actual value is? Buyers and sellers come together to decide on the value depending on the mood and sentiment at the time.
For example, Bitcoin has already had multiple 50%+ corrections in its short history.
Such extreme levels of volatility can be incredibly difficult to manage for the average investor – particularly given that the lack of fundamentals mean there is no clear reason for a recovery (unlike stock markets for example, where markets can be identified as undervalued during corrections, and companies can affect change to cut costs and increase revenue, leading to an inevitable recovery).
As such, for investors who are not already comfortable with a 100% equity portfolio (traditionally the highest risk portfolio that is still considered sensible), it’s difficult to see how their risk profile would be compatible with any significant exposure to cryptocurrencies.
4. Regulatory Uncertainty
In most parts of the world, cryptocurrencies exist in a regulatory grey area.
There are big questions over how this will develop into the future and future regulation could have an impact on both the value and legality of certain transactions.
Given the fact that a significant proportion of crypto use comes from nefarious market participants, it’s not difficult to see how regulation of these transactions and participants could impact the mood and sentiment which drives the overall “value” of cryptocurrencies.
5. Security & Safety Concerns:
While blockchain might be a secure ledger, the platforms that trade cryptocurrencies have historically been vulnerable to hacking.
There have been numerous high-profile thefts from exchanges, resulting in significant losses for end users and investors.
6. Investment Scams & Fraud:
Similarly, the crypto space has been rife with scams and cases of fraud.
From ponzi schemes to the heavily publicised downfalls of Sam Bankman Fried (who was convicted of fraud and stealing $8 billion from customers of his FTX crypto exchange) or Changpeng Zhao (the former CEO of Binance, the worlds largest crypto exchange, who went to prison after violating anti-money laundering laws).
Whilst the lack of oversight and regulation in the crypto market might be heralded as a positive by crypto advocates, the reality is that it can expose investors to some significant risks.
7. The Emergence of ETFs Do Not “Validate” Cryptocurrencies
With the recent slew of crypto ETFs coming to market, many have suggested that reputable companies like BlackRock entering the crypto space brings a certain level of recognition or validation to the asset class as a whole.
Whilst this will pave the way for more people to invest in cryptocurrencies because it improves accessibility – people who perhaps found it too complicated to own cryptocurrency and deal with wallets and storage, etc. can now easily own an ETF within their standard investment or brokerage account – it does not have any real impact on the validity of the asset class itself.
To understand this, you have to think about the motivations of the participants – an investor in cryptocurrency wants the value to increase.
However, companies like BlackRock don’t necessarily care what happens to the value – the cryptocurrency market is a multi-billion-dollar market that BlackRock (and other asset managers like them) had previously been earning zero revenue from.
With over $20 billion now invested in BlackRock’s iShares Bitcoin Trust (IBIT), the management fees of 0.25% will bring in more than $50 million of additional annual revenue for BlackRock.
In the worst possible scenario, should the price of Bitcoin collapse, BlackRock are back to the same position they were in before the launch of the Bitcoin ETF – they have many other funds, and the Bitcoin ETF would simply be wound up and that revenue line closed. Investors, however, would be left with significant losses.
So remember that your interests in cryptocurrencies as an investor are different to the interests of an asset manager.
From an asset management perspective, providing an ETF – and thus charging management fees – means casting your net over an untapped market and instantly capturing an additional revenue line. It’s a business decision hoping to increase income today, not an investment decision hoping to increase value in the future.
Conclusion:
The temptation to get rich quick by investing in cryptocurrencies is strong, but it’s essential to approach this space with caution.
Avoid emotional decisions and behavioural biases (like herding/following the crowd), and make sure you are making informed and logical decisions.
Whilst we would never actively advise it, some clients do like to keep a “fun fund” separate to their life savings and the core of their portfolio. This is a small pot of money – typically 5%-10% of the total portfolio – that can be used to make speculative bets on individual companies, commodities, start ups, etc.
If you do decide to invest in cryptocurrencies, we would suggest that this should be done within your fun fund – money that scratches the itch and provides a controlled level of participation, but won’t derail you if you suffer large losses – not within your primary portfolio, which provides more robust and reliable returns to achieve your long term goals and facilitate the life you want.
Similarly, if you are already invested heavily in cryptocurrencies (i.e. far beyond 5%-10% of your portfolio), it might be a good idea to review your portfolio and think about why you are investing in the first place – reducing your allocation will likely help you to achieve your future goals and more reliably support the life you want to live.
By educating yourself, diversifying your portfolio, and seeking professional advice, you can make more informed decisions that align with your financial goals.
At Abacus, we believe in building wealth through informed decisions & holistic planning, underpinned by a robust evidence-based investment portfolio.
By Technical Team @ Abacus
Please keep in mind that, whilst we aim to update these articles periodically, the content could be subject to future rule changes. Always make sure to speak to a qualified professional to ensure you have the most up to date information and are taking regulated advice around your specific circumstances.